UDF – A Material Omission?

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This is the latest in the United Development Funding  UDF saga

UDF – Reaching Across The Aisle Of Your Private Jet Does Not Equal An Arms’ Length Transaction by Harvest

On December 14, 2015, United Development Funding (UDF) management filed a Form 8?K and press release with management’s rambling response attempting to further lull investors with the old saw, “they just don’t understand our business.” Management has been misleading investors for years, and its response continues further down the path of deception. Not only were management’s responses deceptive; in some cases, the responses were comical. Certain responses have already been debunked on the Harvest Exchange, posted subsequent to the filing of the Form 8?K. Other hollow responses will be discredited in this post and more will follow in the coming days, weeks and months.

However, there was at least one material omission from management’s responses – Deficiency Notes – that needs to be highlighted:

Management failed to discuss the millions of dollars that insiders lost on behalf of public shareholders. The UDF affiliated companies at issue are generally in the business of non?regulated, non?bank lending. Pre?financial crisis, the insiders issued loans from public entities (which they managed but DID NOT own) to their own private entities (which they not only managed but also owned). Management suffered tremendous losses on the loans issued to their own private entities and have been deceiving new unsuspecting investors regarding the reality of their “spectacular” track record ever since. The losses that resulted from poor investment decisions by management eight years ago are still shown as “assets” of the public company. Management calls them “deficiency notes” and “recourse obligations.” In reality, these are just I?OWE?YOUs that management has never repaid.

Deficiency Notes – “The Check Is In The Mail”, For The Last Eight Years

UDF’s management began deceiving its fund investors essentially from the beginning. United Mortgage Trust (UMT), a UDF affiliate with public shareholders and UDF?managed entity, provides the earliest example. Pre?dating the financial crisis, management caused UDF?managed entities to issue loans to insiders, including entities owned by Hollis Greenlaw and Todd Etter, CEO and Chairman respectively, and these insiders in turn loaned these funds to third?parties that turned out to not be creditworthy. When these loans went bad during and subsequent to the financial crisis, the insiders had to foreclose on the collateral which resulted in considerable realized losses to the insiders and their private entities. To date, these losses have never been recognized by UMT, the public entity. Historical losses by the insiders’ private entities ($73 million in I?OWE?YOUs never recognized) and other loans to insiders ($80 million) in their entirety make up for a whopping $153 million, or 84% of UMT’s assets.

In an attempt to cover up these losses, management has issued to themselves opaque and official sounding instruments called unsecured deficiency notes and recourse obligations (“Deficiency Notes”) in the amount of approximately $73 million bearing interest at a rate of 1.75% (apparently, insiders and management believe, despite the realized losses, that they are more creditworthy than the U.S. government). This balance remains unpaid and uncollected for the last 8 years following the financial crisis, despite the non?market interest rate of 1.75%. Why has management not moved to collect on the $73 million Deficieny Note balance? The obvious answer is because Hollis Greenlaw and his insider friends would be forced to collect on themselves. Give up the private jets, country clubs, fancy cars and mansions? Nah, “We’re Good.”

A Deficiency Note is effectively an IOU that management and insiders have not been able to repay. Here is how UMT describes them in its latest Form 10?Q for the quarter ended September 30, 2015:

When principal and interest on an underlying loan is due in full, at maturity or otherwise, the corresponding obligation owed by the originating company to [UMT] is also due in full. If the borrower or [UMT] forecloses on property securing an underlying loan, or if [UMT] forecloses on property securing a purchased loan, and the proceeds from the sale are insufficient to pay the loan in full, the originating company has the option of (1) repaying the outstanding balance owed to [UMT] associated with the underlying loan or purchased loan, as the case may be, or (2) delivering to [UMT] an unsecured deficiency note in the amount of the deficiency.

A Deficiency Note is better defined as a mulligan issued by management to itself. UMT Holdings (UMTH) is the management entity that ultimately owes a considerable amount of these Deficiency Notes to UDF?managed entities and is owned by 10 management insiders, including Hollis Greenlaw and Todd Etter who combine to own 60% of UMTH. UMTH is the external manager of all four public UDF affiliated programs, and accordingly, UMTH’s primary asset is the fee stream from UDF’s public affiliates. Should investors in UDF lose faith in management and replace them, the external manager does not have any apparent means to repay the Deficiency Notes, which represent realized but never recognized (or collected) losses. If any reasonable, non?conflicted fiduciary were appointed to manage UMT, that fiduciary would move swiftly to demand payment and collect on the Deficiency Notes.

Leading to further questions about management credibility, the interest rates on Deficiency Notes owed by Hollis Greenlaw and his management crew of insiders (1.75%) are significantly lower than the interest rates on Deficiency Notes owed by “non?related parties” (14.0%). Does management pretend that insider Deficiency Notes which bear interest at a rate dramatically below a market rate are arms’ length transactions?

When losses are realized, (i) why is management rewarded with 1.75% interest loans (ii) why is there such a large disparity in rates between Deficiency Notes owed by insiders (Hollis Greenlaw and Todd Etter, et al.) and Deficiency Notes owed by “non?related” parties, (iii) why do UDF?managed entities not recognized the losses from its prior failures, and (iv) why would public shareholders of UDF?managed entities pay a “trust administration fee” to management as compensation to manage their historical losses?

Collectively, insiders, including Hollis Greenlaw and Todd Etter, CEO and Chairman respectively, owe $153 million to public shareholders in the form of I?OWE?YOUs and other loans. These obligations show up as “assets” of UDFmanaged entities and account for 84% of total UMT “assets.”

See full PDF below.

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